Fixed Income

Central banks running out of levers to pull

Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

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Economies, policy settings and markets are now poised precariously. Markets expect central banks to ease, and that this will be sufficient to at least stabilise the global growth deceleration. Extreme outcomes – global recession, or alternately, a strong global rebound – do appear somewhat unlikely but there is plenty of room for variability, and limited room for policy error.

Rewind three months and we were cautiously looking for global data to modestly improve, aided by the dovish central bank shift that had already occurred early in the year, with financial conditions having improved alongside markets and with the initial adjustment to higher tariffs appearing to be mostly in the data. This expectation was short-lived, as renewed trade tensions drove manufacturing sentiment and output lower.

It’s difficult to quantify with precision whether the trade war or US policy tightening has been more responsible for the global slowdown in the past year. While the former is more visible both in media headlines and in shifting trade patterns, the latter has worked more subtly, constraining the dollar-linked world largely beyond US borders. A third factor is China’s domestic slowdown, which was already underway early in 2018, though it was obscured at a global level by the US tax boost that peaked in the middle of last year.

Central bankers are responding, but are limited both by the frameworks in which they are operating, and with the tools at their disposal. Following the Peoples Bank of China and a range of smaller central banks, the Fed and the ECB appear set to ease soon. Although this is likely to support asset markets, whether it can arrest decelerating global activity remains to be seen, and it appears unlikely to generate much inflation. This has dawned on markets – against powerful structural forces that are dampening consumer price inflation, and with debt-loads already high, central bankers are losing credibility on achieving their inflation targets. Yet they are doubling down on further monetary easing, even with yields already at historic lows, and with apparent disregard of financial stability risks. Arguments are stirring that fiscal policy could be used more effectively, particularly in countries like Germany and Australia where it has been MIA in recent years.

All this gloomy talk seems at odds with a US economy that has just broken records for the length of its cycle, and low unemployment rates in all the key economies. There are a range of factors explaining both the length and the lower amplitude of this cycle, including the shift to services and the development of capital-lite business models. Despite this, manufacturing remains one of the key swing variables for economic growth, and is driving the deceleration to which central banks are extremely sensitive – because despite all the effort of the past decade, they are still missing inflation targets on the downside.

Not only do we have excessive dependence on impotent monetary policy, we also have increasing political uncertainty. The Trump-Xi handshake at the recent G20 meeting seems only a temporary truce. Although a deal may eventuate given both sides have economic incentives to strike one – and clearly some of the worst case scenarios seems unlikely to transpire – Trump has discovered a new foreign policy weapon: tariffs. The battleground is likely therefore to shift in two ways: to other countries where manufacturing is shifting as a result of tariffs (he’s already tweeting about Vietnam), and to technology on which China is increasingly reliant as it rebalances towards a more service-driven economy.

The RBA has now taken rates to 1% and is prepared to go lower still. Australia is not at negative rates yet, and our last recession was a generation ago, but we’re undoubtedly in the low rate club now. This presents a whole new set of challenges, primarily for savers/investors as cash becomes simply a store of value not a source of return, and for banks as funding and profitability pressure increases.

Much has been made of the rates-equity (and rates-credit) disconnect in current market pricing, with bond markets (in pricing sharp rate cuts) taking an apparently more negative view of economic prospects than their equity counterparts (which have rebounded strongly). Low yields and the shallow amplitude of the cycle both appear to have some causality of this – as the dovish shift by central banks has reinforced the rates- and liquidity-driven reach for yield mentality amid the view that central bank policy is more variable, and more important for markets, than are economic fundamentals. However, while the disconnect can be rationalised, it is an unstable equilibrium that is reliant on policy stimulus stabilising and extending the cycle. While there are examples from the 1990s of ‘insurance cuts’ working, we’re not so confident this time. Our top down models of corporate earnings suggest equity markets are being too optimistic.

Over the June quarter we significantly increased the portfolio’s duration, to now sit 0.75 years longer than benchmark duration of 5.50 years. In particular we bought US duration, which given the stage of the US cycle and the current policy setting offers the best protection to downside economic risks. Alongside the duration buying we trimmed our US inflation-linked exposure, and we are positioned for the yield curve to steepen as cuts are delivered. In Australia we have continued to run a small long duration position as the RBA resigns itself to a lower-for-longer approach, while in Europe we’ve been running a small yield curve flattening position premised on the idea that the ECB needs to stimulate more (whether by bond buying or other measures) but is constrained in lowering the (already negative) cash rate much further.

Our credit position is best summarised as being long in high quality Australian debt and short in lower quality global debt, which leaves us earning a small amount of extra carry versus the benchmark, but positioned to capture some of the likely widening in credit spreads as market volatility increases. While managing the respective sizes of these exposures as opportunities shift, we’ve also been seeking ways to maintain yield, diversify exposures and efficiently manage risk. This is a challenge as there are few pockets of value left, with any excess return on credit assets being largely driven by yield differentials, rather than capital appreciation, from here. Nonetheless, we’ve added to Australian RMBS, now at 7.5%, and are exploring allocations to US mortgages and Asian credit.

Altogether the portfolio stands ready to navigate what appears to be a difficult environment ahead with economies fragile, but little room for policy to disappoint expectant markets.

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